International Journal of Project Management 20 (2002) 107118

www.elsevier.com/locate/ijproman

Evaluating the risks of public private partnerships for

infrastructure projects
Darrin Grimsey a, Mervyn K. Lewis b,*
a
PricewaterhouseCoopers, Spring Street, GPO Box 1331L, Melbourne, Victoria, Australia
b
School of International Business, University of South Australia, North Terrace, GPO Box 2471, Adelaide, Australia

Received 14 October 1999; received in revised form 16 May 2000; accepted 9 July 2000

Abstract
In many countries, limitations upon the public funds available for infrastructure have led governments to invite private sector
entities to enter into long-term contractual agreements for the nancing, construction and/or operation of capital intensive projects.
For the public procurer, there is an obvious need to ensure that value-for-money has been achieved. To the project sponsors, such
ventures are characterised by low equity in the project vehicle and a reliance on direct revenues to cover operating and capital costs,
and service debt nance provided by banks and other nanciers. Risk evaluation is complex, requiring the analysis of risk from the
dierent perspectives of the public and private sector entities. This paper analyses the principles involved, drawing on practical
experience of evaluating such projects to present a framework for assessing the risks, and using as illustration a case study of a
waste water treatment facility in Scotland which is typical of most PPP projects. # 2001 Elsevier Science Ltd. All rights reserved.
Keywords: Public private partnerships; Infrastructure; Project nance; Risk analysis

1. Introduction arrangement has even earlier origins. According to

For most of the post-war period, government has
been the principal provider of infrastructure (at least
outside of the United States). Over the last decade, that
position has begun to change. Faced with pressure to
reduce public sector debt and, at the same time, expand
and improve public facilities, governments have looked
to private sector nance, and have invited private sector
entities to enter into long-term contractual agreements
which may take the form of construction or manage-
ment of public sector infrastructure facilities by the pri-
vate sector entity, or the provision of services (using
infrastructure facilities) by the private sector entity to
the community on behalf of a public sector body.
These arrangements often take the form of a build-
operate-transfer (BOT) arrangement [1]. The acronym
BOT was rst used in the early eighties by Turkey's
Prime Minister Targut Ozal [2]. However, the concept
itself can be traced back to Hong Kong in the late fties
when a privatised vehicle tunnel was rst talked about,
and if regarded as a form of concession or franchise
* Corresponding author. Tel.: +61-8-8302-0536; fax: +61-8-8302-
0512.
E-mail address: mervyn.lewis@unisa.edu.au (M.K. Lewis).
0263-7863/01/$22.00 # 2001 Elsevier Science Ltd. All rights reserved.
PII: S0263-7863(00)00040-5
Monod [3], the rst ``concession'' was granted in 1782 to
Perrier in France and concerned water distribution, which
in the context of this paper seems entirely appropriate.
In Australia, public/private sector infrastructure
arrangements date back to the bicentennial year 1988. In
the UK, the Private Finance Initiative (PFI) was intro-
duced by the Conservative Government in November
1992, widening its privatisation and contracting out
policies to incorporate the provision of infrastructure
and public services by a hybrid approach of combined
public and private sector funding [4]. Procurement was
subsequently redened as the provision of services
rather than the ownership of assets, with partnerships
sought on a range of projects and PFI promoted as a
preferred procurement method a position which did
not change with the incoming Labour administration
which in 1997 built on the initiative with Public Private
Partnerships [5]. The European Commission, through
its grant mechanism, is encouraging PPPs with projects
so far in Portugal, Italy, Netherlands, Greece and Ire-
land [6]. The techniques have been adapted to promote
investment both in local authority services and in infra-
structure projects more generally elsewhere [7,8].
This paper analyzes the risks of PPP arrangements from
the perspectives of the various parties. The character of
108 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
infrastructure investments and the nature of PPPs shape
the riskiness of any individual project. Thus we begin by
examining the nature of infrastructure and how PPPs
are structured.
2. What is infrastructure?
Infrastructure is easier to recognize than dene.
Investment in infrastructure is thought to provide ``basic
services to industry and households'' [9], ``key inputs into
the economy'' [10], and ``a crucial input to economic
activity and growth'' [7], although what is ``basic'', ``key''
and ``crucial'' varies from country to country and from
one time to another (steel production was once regarded
as essential infrastructure). Recently, the activities
regarded as infrastructure investment include:
. Energy (power generation and supply);
. Transport (toll roads, light rail systems, bridges
and tunnels);
. Water (sewerage, waste water treatment and water
supply);
. Telecommunications (telephones);
. Social infrastructure (hospitals, prisons, courts,
museums, schools and Government accommoda-
tion).
These share with other types of xed investment (such
as property development, oce construction [11]) a
number of common characteristics:
. Duration (infrastructure is long-lived, and has a
long gestation process);
. Illiquid (the lumpiness and indivisibility of infra-
structure projects makes for a limited secondary
market);
. Capital intensive (projects are large scale and
highly geared);
. Valuation (projects are dicult to value because of
taxation and pricing rules and embedded options
[12,13] and guarantees).
The result is that evaluation of the projects is a complex
and specialised activity.
The litmus test used to be that infrastructure had to
be provided by government-owned enterprises (the pre-
dominant approach in Europe) or by privately owned
utilities subject to rate of return regulation (the
approach in much of the United States). This conviction
derived from a number of inherent features, such as the
existence of:
. Network services, providing integrative activities
which bind economic activity together;
. Public goods, from which it is dicult (and per-
haps not desirable) to exclude non-payers (the
non-excludability principle);
. Externalities, whereby benets and costs are con-
ferred upon those not a party to the transaction (e.g.
spillovers);
. Natural monopolies, for which scale economies
make it ecient to have only one provider (for
example, of an electricity grid).
The trend away from public to private provision of
infrastructure has been underpinned by a marked
change in thinking and practice on these matters. There
has been the perception, for example, that a move from
`taxpayer pays' to `user pays' (i.e. from ability-to-pay to
the benet principle) in the provision of infrastructure
services (water, power) is likely to be associated with a
better economic use of the services. Many industries
considered to be natural monopolies, e.g. electricity
generation and telecommunications, have been broken
up geographically into dierent regional rms or, with
deregulation, separated into competitive (or potentially
competitive) sectors vis-a-vis those sectors that remain
natural monopolies (the distinction between power sup-
ply and high-voltage transmission, and between railway
operation and rail track services). In those activities
which have natural monopoly characteristics, substitu-
tion of price-cap regulation for rate-of-return regulation
(i.e. xing of maximum prices rather than the mark up
over costs) has created strong incentives to reduce costs,
while third party access to certain facilities that are not
economic to duplicate has widened competition in the
upstream and downstream markets served by the facil-
ities. All of this has laid the groundwork for PPP
arrangements.
3. PPP arrangements
Confusion sometimes exists between `infrastructure
nancing' and `infrastructure investment'. The former
can arise from the privatisation of existing facilities,
whereas infrastructure investment involves the develop-
ment, operation and ownership either by the private
sector alone or in a joint venture between government
and the private sector entity. The distinction is analo-
gous to buying an existing oce block, already fully let,
as opposed to developing a new site the attendant
risks are obviously quite dierent in the two cases.
Accordingly, PPPs can be dened as agreements
where public sector bodies enter into long-term con-
tractual agreements with private sector entities for the
construction or management of public sector infra-
structure facilities by the private sector entity, or the
provision of services (using infrastructure facilities) by
the private sector entity to the community on behalf of
a public sector entity. They can take many forms and
may incorporate some or all of the following features
[14]:
 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
. The public sector entity transfers facilities con-
trolled by it to the private sector entity (with or
without payment in return) usually for the term of
the arrangement;
. The private sector entity builds, extends or reno-
vates a facility;
. The public sector entity species the operating
features of the facility;
. Services are provided by the private sector entity
using the facility for a dened period of time (usually
with restrictions on operations and pricing); and
. The private sector entity agrees to transfer the
facility to the public sector (with or without pay-
ment) at the end of the arrangement.
A classic example of a BOT arrangement is the third
Dartford Crossing of the River Thames linking two
stretches of the M25 motorway circling London, to be
operated (with virtually guaranteed toll income) by the
vehicle company for up to 20 years, following which the
facility will revert to the UK government. In Australia,
projects such as the Sydney Harbour Tunnel and the
City Link (linked motorways) project in Melbourne are
also BOT arrangements.
With a BOO (build-own-operate) project, the private
sector entity nances, builds, owns and operates an infra-
structure facility eectively in perpetuity. An example
comes from the water treatment plants serving parts of
South Australia. These facilities are nanced, designed,
built and operated by a private sector rm to process
raw water, provided by the public sector entity, into l-
tered water which is then returned to the public sector
utility for delivery to consumers.
Although governments have been motivated into
entering into PPP arrangements by the desire to reduce
debt (and contain taxation), another consideration has
been the benets of sharing nancial risks and rewards
between public and private sector bodies. We now
examine these risks.
4. Risks
Much of the risk of a PPP project comes from the
complexity of the arrangement itself in terms of doc-
umentation, nancing, taxation, technical details, sub-
agreements etc involved in a major infrastructure ven-
ture, while the nature of the risk alters over the duration
of the project. For example, the construction phase of
the project will give rise to dierent risks from those
during the operating phase.
Some idea of the complexity is given in Fig. 1. The
project concerned is the Almond Valley and Seaeld
(AV&S) project involving the construction and opera-
tion of a water treatment facility for East of Scotland
Water (ESW), with a services contract over 30 years
109
between ESW (the public procurer) and Stirling Water.
There is also a separate operating agreement between
Stirling Water and Thames Water, the private sector
operator of the works. The project reached nancial
close in March 1999 and the gure sets out the links and
key contractual arrangements between the parties
involved.
From the viewpoint of the public procurer, there is an
obvious need to ensure that money has been spent eco-
nomically, eciently and eectively. At its simplest, the
Government seeks to utilise private sector nance in the
provision of public sector infrastructure and services
and thereby achieve value-for-money. Value-for-money,
dened as the eective use of public funds on a capital
project, can come from private sector innovation and
skills in asset design, construction techniques and
operational practices, and also from transferring key
risks in design, construction delays, cost overruns and
nance and insurance to private sector entities for them
to manage. However, in some cases, the emphasis on
risk transfer can be misleading as value-for-money
requires equitable allocation of risk between the public
and private sector partners, and there may be an inher-
ent conict between the public sector's need to demon-
strate the value-for-money versus the private sector's
need for robust revenue streams to support the nan-
cing arrangements [15].
From the perspective of the project sponsors, PPP
(and PFI) is essentially project nancing, characterised
by the formation of a highly-geared special purpose
company for the project vehicle and consequently a
reliance on direct revenues to pay for operating costs
and cover debt nancing while giving the desired return
on risk capital. Although there are exceptional cases
such as the Hong Kong Harbour Tunnel which started
making a prot four years after opening, these arrange-
ments typically last for long periods and take a long
time to generate a prot. It is therefore important to
have a clear understanding of the principles of limited-
recourse nancing. PPP projects are viable only if a
reliable, long-term revenue stream can be established.
The risk that the predicted revenues do not materialise
is the greatest risk to the commercial viability of a
project.
This risk is borne by those providing nance or
nancial guarantees. Straight equity participation is
generally low, only 5% of the total funding (4.95 mil-
lion out of funding of 99 million) in the case of the
AV&S project. This situation is more starkly illustrated
by the designconstructmanagenance (DCMF) of a
PFI private prison currently operating in Bridgend,
South Wales which was funded with only 250,000 of
equity constituting 0.3% of the total funding of 83.5
million. Subordinated debt is often regarded as the
equivalent of equity, but this comprises only a further
14% of funds invested in the AV& S project.
110 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118

Fig. 1. Contractual arrangements in a PFI/PPP project.

 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
Typically, the providers of nance look to the cashow
of the project as the source of funds for repayments.
Financial security against the project company itself is
not sought because the company usually has minimal
assets and because the nancing is without recourse to
the sponsor companies. However, performance guaran-
tees are often made available by the sponsor companies
in favour of the lenders. Thus the key principle for large
PPP projects is to achieve a nancial structure with as
little recourse as possible to the sponsors whilst at the
same time providing sucient credit support so that the
lenders are satised with the credit risks.
What are the risks? At least nine risks face any infra-
structure project [1619]:
. Technical risk, due to engineering and design fail-
ures;
. Construction risk, because of faulty construction
techniques and cost escalation and delays in con-
struction;
. Operating risk, due to higher operating costs and
maintenance costs;
. Revenue risk, e.g. due to trac shortfall or failure
to extract resources, the volatility of prices and
demand for products and services sold (e.g.
minerals, oce space etc.) leading to revenue de-
ciency;
. Financial risks arising from inadequate hedging of
revenue streams and nancing costs;
. Force majeure risk, involving war and other cala-
mities and acts of God.
. Regulatory/political risks, due to legal changes
and unsupportive government policies;
. Environmental risks, because of adverse environ-
mental impacts and hazards;
. Project default, due to failure of the project from a
combination of any of the above.
Successful project design requires expert analysis of
all of them and the design of contractual arrangements
prior to competitive tendering that allocate risk burdens
appropriately. For this purpose the risks can be broadly
categorized as global or elemental [20]. Global risks are
those risks that are normally allocated through the
project agreement and typically include political, legal,
commercial and environmental risks. Elemental risks
are considered as those associated with the construction,
operation, nance and revenue generation components
of the project.
Most of these risks are common to any project nancing
activity, and apply with more or less force depending on
the project concerned. With some PPP agreements, rev-
enue risk and market risk might be low, indeed negligible.
For example, the revenue from a toll bridge might be
more assured than that of an oileld, while a private
prison is likely to operate with a higher occupancy rate
(e.g. 100%) than a luxury hotel! At the same time,
111
however, there is clearly the risk of losses arising from a
changing political climate toward the provision of pub-
lic services by the private sector, while the prices
charged for many public sector services are politically
sensitive and may be price-capped in some way.
Nevertheless, in principle, the risks of PPP projects
seem little dierent from those of other project nan-
cing activities, and can be evaluated using much the
same basic techniques. The critical question, as always,
is whether revenue streams can cover operating costs,
service debt nance and provide returns to risk capital.
Consider the case of infrastructure in the form of a
power plant. Sponsors of the power project borrow
money to build a generation plant. The sponsors con-
tract to supply power to utilities, projecting that the
contract revenues will suce to pay debt service and
generate prots. But risks abound. Will the plant actu-
ally be built on time? Will the plant work? And will the
market value of the contracts enable participants to
avoid an income shortfall? Can rates be raised to levels
that more or less equal the utility's costs for providing
electricity, an activity that has historically been regu-
lated by government? None of these questions can sen-
sibly be dodged or ignored in project evaluation.
Ultimately, the `bottom line' (i.e. project default risk)
is borne by the nanciers, and when considering this
scenario the uncertainties concerning future cash ows
can be thought of as falling into two categories:
1. Moderate (and perhaps not so moderate) devia-
tions from estimated cash ow projections, due to
uctuating prices, costs, timing delays, minor
technical problems, etc.
2. Disasters to a project, due to a major cost over-
run, downturn in the economy, change in legal
rulings, alteration to the political climate, envir-
onmental disaster etc, which could lead to project
failure and bankruptcy.
The dierence here is not simply one of scale. Rather,
the distinction we have in mind recalls that made by
Frank Knight in his classic 1921 treatise [21]. Knight
distinguished sharply between one type of situation,
which he called ``risk,'' and another situation altogether,
which he named ``uncertainty.'' In both cases, the actual
future outcome is not predictable with certainty. But in
the case of risk, the probabilities of the various future
outcomes are known (either exactly mathematically, or
from past experience of similar situations). In the case
of uncertainty, the probabilities of the various future
outcomes are merely ``wild guesses'' because
the `instance' in question is so entirely unique that
there are no others or not a sucient number to
make it possible to tabulate enough like it to form a
basis for any inference of value about any real
probability in the case we are interested in. (p. 226).
112 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
Knight went on to argue that the main function of the
`entrepreneur' is to bear the brunt of this uncertainty of
the future. The prots of enterprise (`pure prots' over
and above interest payments on debt capital and/or
dividend payments to shareholders) is a reward for
facing this uncertainty.
However, the reality in the nancing of projects is
often quite dierent to that envisaged by Knight. For
example, developers who put up blocks of oces or ats
for future sale commonly set up a new limited company
for each new building. This company borrows money
and/or sells equity shares. If the building fails to make a
prot, this particular company goes bankrupt. But the
sponsor may survive. The successful entrepreneur is
often one who knows how to shift the burden of uncer-
tainty onto others, in particular investors and/or cred-
itors, in such a way that he himself will survive, waiting
for a more propitious time for others to again be per-
suaded to take chances with their money. As Blatt [22]
puts it, the prudent entrepreneur reacts to true uncer-
tainty by attempting to make others bear the con-
sequences.
Clearly, an analysis of the nature of the risks [23
25] and who bears them is vital, and the evalua-
tion of projects requires the use of several risk analysis
techniques tailored to suit the interests of the various
parties to the project. Nevertheless, the Knightian dis-
tinction remains. At least in theory, risk can be insured
against, diversied, calculated with dierent prob-
abilities, but true uncertainty or disaster scenarios are
something else again. How are risks handled in practice?
To answer this question we will look at risk analysis
from the dierent perspectives of the parties to the
AV&S project.
5. Risk analysis in practice
The AV&S project constitutes a major initiative being
undertaken by ESW to improve the quality of the water
within the River Almond and the Firth of Forth and to
implement an alternative to the current practice of dis-
posal of sewage sludge at sea. The project is driven by
ESW's requirements to comply with its obligations
under the Urban Water Treatment (Scotland) Regula-
tions 1994. The project is just one of around ten PFI
schemes currently in procurement with the three Scot-
tish water authorities in order to comply with new reg-
ulatory standards to be in force by the end of December
2000. ESW alone has indicated that capital investment
over 5 years of 850 million is required to achieve the
required standard in its region.
Following a long procurement process of over 2 years,
in March 1999 ESW entered into the Services Contract
with Stirling Water pursuant to which Stirling Water
agreed to upgrade and improve the treatment of waste
water from the feeding catchments of Almond Valley
and Seaeld and to provide new arrangements as an
alternative to the disposal of sewage sludge at sea. The
main parties to the project and an indication of their
connecting relationships are shown in Fig. 1, but in
summary:
. ESW is the procuring entity and the authority
responsible for providing water, collecting and
treating waste water and disposing of sewage
sludges within its region;
. Stirling Water is the special purpose company set
up for the purpose of nancing, constructing and
operating the AV&S project;
. Thames Water, MJ Gleeson and Montgomery
Watson are the project sponsors providing risk
capital and acting respectively as the operator,
contractor and designer to Stirling Water; and
. MBIA is providing the credit enhancement insur-
ance policy so that the project can attain a credit
rating of AAA. While institutional investors pur-
chased the bonds, the MBIA policy uncondition-
ally and irrevocably guarantees scheduled
repayments of principal and interest under the
bonds issued and therefore MBIA eectively
assumed the role of senior lender.
Stirling Water funded the 99 million project from:
. 79.217 million of 27.5 year AAA rated credit
enhanced bonds paying a xed coupon of 5.822%;
. 14.835 million of subordinated debt provided by
Thames Water. The subordinated debt has the same
term as the bonds and a similar interest rate; and
. 4.95 million of equity split between Thames Water
(49%), MJ Gleeson (41%) and Montgomery Wat-
son (10%). The internal rate of return on the equity
was projected to be 16.56% nominal and 12.5%
real at nancial close.
6. Project risks
Stirling Water as the project vehicle has taken on
certain construction and operating risks over the con-
tract period but has allocated away contractually many
of these risks to the construction contractor and the
operator, as is usual under such arrangements. Stirling
Water retained the risk that projected maintenance costs
are exceeded, such as those arising from shorter than
anticipated asset life spans, increased ination on spe-
cic items of plant and machinery or the requirement to
carry out unexpected repairs.
Once the plants are commissioned Stirling Water
receives payment based on the volume of waste water
treated. The payment mechanism is the key to the risk
apportionment and is not like a normal PFI deal where
 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
the operator is paid on making the facility available.
The contract is more akin to the UK's design, build,
nance and operate (DBFO) programme for roads
where shadow tolls are paid within payment bands (ie.
dened levels of trac volume), a structure in fact
devised by PricewaterhouseCoopers. The aim of such a
structure is to allocate a sucient element of volume
risk to the service company and also to limit the
authority's exposure to an increase in payments arising
from a greater than anticipated volume of waste water
delivered. The AV&S payment bands are as follows:
. The rst band for waste water treatment is for
between 0 and 90,000 cu m pa and pays 13.883 p.
This band is designed to generate sucient rev-
enue to cover xed operating and maintenance
costs and outstanding amounts due under the
bond issue;
. The second band for waste water treatment is for
between 90,000 cu m pa and 101,000 cu m pa and
pays 9.2555 p. This band is designed to provide
sucient revenue to meet payments under the
subordinated debt; and
. The third band for waste water treatment is for
between 101,000 cu m pa and 107,000 cu m pa and
pays 4.628 p. This band is designed to meet the
shareholders' target investment returns.
. The fourth band for waste water treatment is for
ows in excess of 107,000 cu m pa and is free of
charge. This band is designed to cap the payments
to be made by ESW.
Payment above the third band eectively is capped
thereby limiting ESW's exposure to payments under the
contract, while there is a separate rate for the treatment
and disposal of imported sludge. The contract provides
for payment to be subject to performance-related adjust-
ments geared to any breaches in environmental discharge
consent standards set by SEPA. A major concern for
Stirling Water is the impact of the quality of the waste
water delivered to the works by ESW upon the opera-
tor's ability to treat the waste water to a standard which
results in the discharged waste water and sludge com-
plying with the required consents. For this reason the
contract contains a list of inuent concentration levels.
In the event that these are exceeded and as a result
Stirling Water is unable to treat the waste water to the
required standard, then Stirling Water will nevertheless
be entitled to payment in full.
Stirling Water is protected through the contract
against circumstances inuenced by ESW that would
impact on the volume of waste water such as the issuing
of trade euent discharge consents, the introduction of
water metering or greatly increased capital investment
in the sewerage infrastructure leading to a reduction of
water inltration to the sewers. However, under the
payment mechanism, failure to achieve forecast levels of
113
volume throughput or suering larger than expected
deductions for poor performance would result in lower
than forecast revenues, which would impact on the
equity return and may adversely eect Stirling Water's
ability to make repayments of subordinated debt and
even coupons on the bonds.
The proportion of the tari indexed to the retail prices
index (RPI) is 65%, applied to all three revenue-gen-
erating bands. The remaining 35% of the tari is not
subject to indexation but is xed for the contract term.
Proportionally this division approximates to the percen-
tage of the nominal cash ow used to service the bond
nancing. However, it is possible that there will not be a
precise match between Stirling Water's revenues and
costs resulting in costs rising faster than revenue arising
under the contract and this risk is borne by Stirling
Water and its shareholders.
The risk of any adverse changes in law is an important
element and on the AV&S project the risk is shared
between ESW and Stirling Water over the rst ten years
of the contract. After this time, the risk is borne by ESW.
7. Risk analysis
Having sketched the key risks inherent in the project
it is important to look at the nature and quantum of
risk from the dierent perspectives of the main parties
to the project. As a guide to the methodology employed,
Fig. 2 provides a ow chart of the analytical approach.
For each of the three major groups of entities, it sum-
marises their risk perspective, the key variables, the major
risks they face, and the risk analysis which is appropriate.
There are several risk analysis techniques available ran-
ging in complexity from simple expected cost analysis
through sensitivity analysis and on to more complex
probabilistic techniques involving computer-aided sta-
tistical sampling. The technique that should be used, as
indicated, is largely dependent on the exposure of the
party to the risk and the nature of the return expected
by the party.
7.1. Procurer
ESW, as the procurer, was only interested in the
expected costs in the form of the payments they would
have to make under the contract. In accordance with
Government guidelines the projected payments to each
of the bidders were discounted at 6% real and summed
to derive the net present value (NPV) of each of the
bids. From ESW's perspective, the risk analysis centred
on establishing equality of treatment between bidders
for bid evaluation and to facilitate a comparison with
the public sector comparator in order to demonstrate
value-for-money in NPV terms. The value-for-money
criterion should establish the best means for achieving
114 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118

Fig. 2. Flow chart of analytical approach.

 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
the required project function for the least cost. Part of
the value-for-money analysis involves a comparison of
the project against a traditional public sector procure-
ment and operation route known as the public sector
comparator. The main risks analysed from this per-
spective concerned the following issues:
. The contract was conditional on obtaining plan-
ning consent and a risk-sharing mechanism was
agreed whereby ESW would pay for a proportion
of the planning change costs through an adjust-
ment to the taris;
. Stirling Water had qualied their bid in relation to
passing the risk of costs resulting from nds, such
as antiquities, being uncovered during the con-
struction phase of the project back to ESW; and
. Bidders were also asked to calculate the impact of
delay to the programmed contract signing date in
terms of the acceleration costs necessary still to
achieve the commencement date for the main per-
iod for waste water treatment of January 2001.
ESW and its advisers made an assessment of the
likely delay and adjusted the bids accordingly.
The risks were analysed by establishing the expected
cost to ESW of these risks and adjusting the NPV of the
bid. In the case of Stirling Water this resulted in approxi-
mately a one percent increase in the NPV of the bid. When
compared with the competitors, this led to the conclusion
that their bid provided ESW with the most economic-
ally advantageous proposal relative to the other bidders.
Under the Project Development Agreement, ESW
also retained the risk of movements in the underlying
interest rates up to nancial close, a practice common to
such projects. In this case, the specic risk is that any
increase in the level of interest rates, and thus of the
nancing costs for the project, prior to nancial close
will result in a higher tari being levied, while the dis-
count rate used in the analysis is xed at 6% real.
Interest rate risk is generally dicult to quantify with
any real precision. To get a feel for the likely impact of
this risk, sensitivity analysis was carried out on the
nancial model that yielded the results shown in Table
1. The sensitivity analysis indicates that ESW were rea-
sonably well protected against movements in the
underlying interest rate with a moderate rate increase of
1% leading to an increase in the NPV of the cost stream
of the project of 3.6% (the approximate gradient of the
interest rate sensitivity relationship).
ESW also carry ination rate risk to the extent that
RPI deviates from that projected in the nancial model.
Whilst it is generally accepted that there is a link between
interest rates and ination the analysis looked at these
independently since ination rates may not be reected
fully in the ination premia built into interest rates [26].
Like interest rates, ination is dicult to predict and
115
Table 1
Procurer: interest rate sensitivity
Interest rate % increase/decrease in NPV
of expected cost stream from
base case
Base case 1% 3.3
Base case 0.5% 1.7
Base case Base case NPV
Base case +0.5% +1.8
Base case +1% +3.6
Base case +1.5% +5.4
Base case +2% +7.5
sensitivity techniques were again used. Table 2 shows
the variation in the NPVs at ination assumptions ran-
ging from 2 to 6%. The NPVs are reduced at higher
ination rates partly because the debt element of the
nancing being serviced by the revenue stream of the
project has not been indexed. The eect of discounting
an element of the project's revenue stream xed in
nominal terms at a xed discount rate of 6% real will
lower the NPV of the debt element of the revenue
stream at higher ination rates and therefore lower the
overall NPVs. The analysis demonstrates that ESW is
well protected against the risk that ination increases in
the future.
It is widely acknowledged that sensitivity analysis is
limited to indicating the potential eects upon an out-
come, in this case the NPV, if a movement in the vari-
able occurs. Critics of this form of analysis argue that
unless some indication of how likely it is that a quanti-
ed movement will occur then this form of analysis is
not of much use. This argument ignores the fact that
some important economic variables cannot easily be
quantied in terms of likelihood and extent of change.
Who in the UK, for example, during the late seventies
could have reasonably predicted that ination would be
3% or less in the late nineties, a period of only 20
years that is, 10 years less than the contract term in
this case study? Under such circumstances, sensitivity
analysis provides a useful tool for analysing these risks
in terms of bid evaluation.
Table 2
Procurer: ination sensitivity
RPI assumption (%) % increase/decrease in NPV
of expected cost stream from
base case
2 +4.79
3 +1.47
3.5 Base Case NPV
4 1.36
5 3.79
6 5.90
116 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
7.2. Sponsors
From the sponsors' perspective, the risk analysis cen-
tres around establishing the potential impact on the
equity return. For the purpose of this exercise, the dis-
tinction between subordinated debt and equity is
ignored because the degree of subordination gives sub-
ordinated debt virtually the same characteristics as
equity. Subordinated debt is favoured in the UK
because it enables the sponsors to extract cash from the
project vehicle where dividends would be restricted by
the prot and loss account and also because the interest
is tax deductible. In order to review Stirling Water's
nancial proposals from the sponsors' perspective an
analysis of the impact of the equity risks on the nancial
model had to take account of potential upside as well as
downside risk.
A simulation exercise was therefore carried out using
the following methodology. First, a realistic downside
(and upside) case for each risk was dened by ESW's
technical adviser Halcrow Crouch to establish a trian-
gular risk distribution for each risk. The relevant risks
for this analysis were:
. volume risk;
. the risk of mid-life capital expenditure and asset
management costs being greater than forecast;
. operating cost; and
. operating performance.
Whilst construction delay is an important project risk
it was not included. This was because the risk analysis
looked at the risks from the project sponsors' perspec-
tive as equity investors in Stirling Water. For them,
delay risk is dealt with contractually through liquidated
damages contained in the construction contract and
also business interruption insurance. Eectively, there-
fore, the risk resides with the construction contractor
and the insurer and not with the project sponsors.
Second, having delineated the relevant risks for
examination:
. a simulation exercise was carried out using the
@RISK computer software package to determine
the distribution of the relevant risks overall. Then,
third,
. from this analysis an assessment was made of the
impact on the blended equity/subordinated debt
IRR.
The @RISK software package uses a Monte Carlo
simulation process to perform a risk analysis. Simula-
tion in this sense refers to a method whereby the dis-
tribution of possible outcomes is generated by letting
the computer recalculate the nancial model over and
over again, each time using dierent randomly selected
sets of values for the probability distributions contained
in the spreadsheet model. In eect, the computer is trying
all valid combinations of the values of input variables to
simulate all possible outcomes.
A summary of the results of the quantitative risk
analysis on the Stirling Water nancial model is shown
in Table 3. This analysis suggests that the sponsors are
unlikely to achieve the base level rates of return, yet are
taking a reasonable amount of nancial risk commen-
surate with risk capital investments in such projects.
Although the relevant risks modelled contained upside
potential, the analysis also indicates that there is, over-
all, no likely nancial upside for the sponsors. The main
opportunity for nancial upside comes from increased
waste water volumes, but the payments made by ESW
are capped as described earlier. Also, the procurer in
this case was in a strong bargaining position; England
and France have some of the largest water companies in
the world and they were vying for a foothold in the
relatively small Scottish market.
7.3. Senior lenders
For senior lenders the nature of non-recourse or lim-
ited recourse funding clearly carries a rather dierent
risk or credit assessment than a conventional full
recourse loan where the enforcement of security by the
lender is additional to its ability to sue the borrower, and
the lender can assess the value of the assets used as col-
lateral. With project nancing, the facilities often do not
have a capital worth, in terms of a wide market, to which
lenders would wish to attribute value. Lenders, of course,
insist on having the opportunity to step in and rescue a
failing project but they cannot simply sell o the asset to
realise value. In contracts such as AV&S, the assets
essentially take the form of the contract with the pro-
curing authority. It is therefore understandable that
senior lenders tend to take a pessimistic view where risk
analysis is concerned. The key dierence between the
senior lenders and the sponsors is that for the senior lender
holding debt rather than equity there is never any potential
upside gain in the project, only downside risk that could
reduce the ability of the borrower to make principal and
interest payments under the loan agreement.
Table 3
Sponsors: equity/subordinated debt risk analysis
Simulation Decrease in blended
equity IRR
Minimum simulation result Base case 7.17%
5% probability of returns being less than: Base case 5.48%
25% probability of the returns being less than: Base case 3.9%
50% probability of the returns being less than: Base case 2.52%
75% probability of the returns being less than: Base case 1.47%
95% probability of returns being less than: Base case 0.57%
Maximum simulation result Base case 0.06%
 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
Senior lenders therefore focus on cover to the income
stream over the term of the loan and analyse risk to
establish robustness by reference to cover ratios. The
most important of these ratios are the loan life cover
ratio (LLCR) and the annual debt service cover ratio
(ADSCR). The LLCR provides a snap shot on a given
date of the NPV of the projected cashows from that
date until retirement of the loan relative to the loan
outstanding on that particular date. The ADSCR is an
historic ratio that measures the cashow for the pre-
vious year in relation to the amount of loan principal
and interest payable for that period.
The sensitivities tested from the lenders' perspective
are intended to capture the risks left with the service
company rather than the project as a whole, taking
account of the fact that it will seek to mitigate key risks
by allocating them away contractually. The main
instruments used for allocating risk will be:
. The Design and Construction (D&C) Contract
which mitigates the Service Company's exposure
to design risk and construction cost and time
overrun risk; and
. The Operation and Maintenance (O&M) Contract
which mitigates the Service Company's exposure
to performance risk and operations and main-
tenance cost risk.
It is therefore crucial to the nancial robustness of
bids, given the highly geared nancing structure envi-
saged, that these risks should be allocated away from
the service company under strong contracts to suitable
counterparties. However, even when risk is transferred
contractually some residual risk will remain with the
service company. For instance, if the operating costs
turned out to be signicantly greater than originally
forecast it is conceivable that the service company could
decide that it was in its best interests to share the pain
with the O&M Contractor by agreeing to a price
increase to absorb some of the increased cost, rather
than running the risk of the O&M Contractor aban-
doning the contract. The operating expenditure (OPEX)
and capital expenditure (CAPEX) sensitivities tested are
intended to reect this residual risk.
Table 4 below displays the results of the robustness
analysis on Stirling Water's nancial model. The
ADSCR and LLCR (see earlier denitions of these
cover ratios) only fall below the minimum requirement
(ADSCR of 1.15 and LLCR of 1.15) under the OPEX,
Flow and Combined Scenario. However, in no case do
the ADSCR or LLCR fall below 1.0, which would
indicate a default under the loan agreement. This ana-
lysis indicates to the senior lenders that the Stirling
Water nancing plan is reasonably robust to support
the level of funding anticipated.
117
Table 4
Senior lenders: robustness analysis of cash ows
Sensitivity Changea ADSCR LLCR
(%)
Base case nancial model 1.26 1.32
Construction cost +3 1.26 1.32
OPEX +12.5 1.08 1.15
Downside ow 1.07 1.12
Midlife CAPEX +10 1.24 1.29
Operational performance 2 1.20 1.26
Combined downside: 1.04 1.10
downside ow plus midlife CAPEX
a
As dened by ESW's technical adviser (see text).
Overall, the combination of risk analysis techniques
used on the AV&S project demonstrated that:
. The project delivers value-for-money to the procur-
ing entity ESW and satises the main government
criteria for investing in capital projects;
. The project has reasonable but not excessive
upside potential for the project sponsors and
downside potential commensurate with the levels
of return anticipated in the base case; and
. The downside sensitivity testing suggests that the
project is suciently robust and nancially stable
from the viewpoint of lenders.
8. Conclusion
Project nance and PPP/PFI arrangements are foun-
ded on the transfer of risk from the public to the private
sector under circumstances where the private sector is
best placed to manage the risk. The general principles
are common to all public sectors insofar as the projects
seek to shift risk from the public sector to the supplier
and oer a prot incentive to the private sector in
return. However, the principal aim for the public sector
is to achieve value-for-money in the services provided
while ensuring that the private sector entities meet their
contractual obligations properly and eciently.
Value-for-money and risk transfer principles accep-
ted, fundamentally PPP projects are viable only if a
robust, long term revenue stream, over the period of the
concession, can be established. A framework for inves-
tigating and carrying out an analysis of the risks has
been outlined in this paper that systematically views
project risk from the perspectives of the procuring
entity, the project sponsors and the senior lenders. For a
project to be successful, the diering (and conicting)
needs of these parties must be satised in the risk allo-
cation process, and this would seem to have been
achieved in the waste water treatment project used to
illustrate the application of the framework.
118 D. Grimsey, M.K. Lewis / International Journal of Project Management 20 (2002) 107118
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